Dividend Investors – Do Not Forget About Total Returns

by Dividend Growth Investor | June 20, 2012 12:30 pm

Dividend investors often get into the strategy because the dividend component[1] of total return is more stable[2]. This makes it an ideal strategy for retirees to live off dividends[3] and not be dependent on short term market fluctuations.

Some dividend investors however focus exclusively on yield[4], which could result in sub-par performance. Choosing a utility yielding 5%-6% today with a high payout ratio and low or no earnings and dividend growth over a dividend growth stock such as Johnson & Johnson (NYSE:JNJ[5]) might lead investors disappointed down the road. Even if retirees are looking for high dividend stocks for current income, they should not ignore the fact that they would likely remain retired for two or three decades. A stock yielding 6-8% today that does not grow distributions would deliver the same amount each year.

The purchasing power of these dollars would be much lower however. In fact even a 3% inflation would decrease purchasing power by 50% over 24 years. This means that a Coca-Cola (NYSE:KO[6]) can selling for 75 cents today would likely cost $1.50 in 24 years. On the other hand, a company which yields 3% today, but grows distributions at 6% would pay a yield on cost[7] of 12% in 24 years. Even if the purchasing power is cut in half by inflation, this is still a respectable inflation adjusted yield on cost of 6%.

Utilities are dividend staples, which investors usually purchase in their search for current income. Utilities typically provide above average yields[8], although their dividend payments do not grow much over time. As a result the purchasing power of these high yields decreases each year. Most of these utilities also pay most of their earnings out in the form of dividends. This means that if these companies could easily cut distributions if cost of capital increases or regulators are not willing to increase rates to provide for sufficient return on new investment. If this happens, investors would suddenly realize a much lower yield on cost on their original investment which would also have much lower purchasing power.

Of the 15 companies included in the Dow Jones Utilities index, only a handful have not had dividend cuts over the past 2 – 3 decades.

[9]

It is evident, that utility dividends are highly cyclical. In essence, the best time to purchase utility stocks might be right after a dividend cut.

Investors should focus on total returns[10] as well, because increases in share prices would protect the purchasing power of the principal over time. By focusing solely on obtaining the highest current yield, investors could actually risk depleting their principal and suffering from dividend cuts at the worst times imaginable.

The types of companies which are suitable for all investors, no matter what their age, are dividend growth stocks. The types of companies investors should look for include:

Procter & Gamble (NYSE:PG[11]), together with its subsidiaries, provides consumer packaged goods and improves the lives of consumers worldwide. The company operates through six segments: Beauty, Grooming, Health Care, Pet Care, Fabric Care and Home Care, and Baby Care and Family Care. The company has raised dividends for 56 years in a row, and has managed to boost them by 10.90% per year over the past decade. Yield: 3.60% (analysis[12])

Coca-Cola (NYSE:KO[6]), a beverage company, engages in the manufacture, marketing, and sale of nonalcoholic beverages worldwide. The company has raised dividends for 50 years in a row, and has managed to boost them by 10.10% per year over the past decade. Yield: 2.70% (analysis[13])

McDonald’s (NYSE:MCD[14]), together with its subsidiaries, franchises and operates McDonald’s restaurants primarily in the United States, Europe, the Asia Pacific, the Middle East, and Africa. The company has raised dividends for 35 years in a row, and has managed to boost them by 27.40% per year over the past decade. Yield: 3.10% (analysis[15])

Chevron (NYSE:CVX[16]), through its subsidiaries, engages in petroleum, chemicals, mining, power generation, and energy operations worldwide. It operates in two segments, Upstream and Downstream. The company has raised dividends for 25 years in a row, and has managed to boost them by 8.80% per year over the past decade. Yield: 3.50% (analysis[17])

Philip Morris (NYSE:PM[18]), through its subsidiaries, manufactures and sells cigarettes and other tobacco products. The company has raised dividends since 2008, and has managed to boost them each year since. Yield: 3.50% (analysis[19])